The Qualified Small Business Stock (“QSBS”) exclusion is a provision of the Internal Revenue Code (“IRC”) which allows eligible non-corporate taxpayers to potentially exclude millions of dollars of gain from federal income tax when they sell shares in their company. The tax incentives created by the QSBS rules are found in IRC Section 1202, which was enacted in 1993 to encourage taxpayers to start and invest in certain types of small businesses for which Congress believed there had historically been difficulty attracting equity investment. QSBS is in essence a tax incentive (i.e., a “tax break”) created by the federal government to promote and encourage taxpayers to create and invest in certain types of small businesses.
The QSBS gain exclusion is a powerful tax incentive for small business owners because it allows eligible taxpayers to exclude from federal income tax the greater of up to $10 million or 10 times their adjusted basis in their QSBS stock at the time of sale. I emphasize the fact that the exclusion is for the greater of $10 million or 10 times a taxpayer’s adjusted basis in their QSBS stock because, as discussed further below, with the right advice and planning, taxpayers can potentially increase their exclusion through use of the 10 times basis rule.
The Popularity of Qualified Small Business Stock
Today, the QSBS exclusion provisions are often utilized by founders, entrepreneurs, and investors in parts of what can broadly be described as the innovation economy. As discussed below, the QSBS exclusion for many years did not receive the wide attention of the general public, in part due to the somewhat complicated eligibility requirements to take advantage of this tax incentive. More recently, knowledge about the QSBS provisions has become more mainstream with AngelList, Morgan Stanley, Wealthfront, Carta, Forbes, NerdWallet, Investopedia, the SBA, and numerous accountants and attorneys, including myself, all writing about the exclusion. The QSBS provisions have even garnered attention from the New York Times, which has written about one prominent technique for multiplying the QSBS exclusion, known by tax practitioners as “stacking”.
While the Qualified Small Business Stock rules have been around for approximately thirty years, due to (a) a top marginal corporate income tax rate which, prior to the enactment of the 2017 Tax Cuts and Jobs Act, had been 35%, (b) the perceived tax inefficiency of C corporations (i.e., the so called “double tax” where income of a C corporation is taxed once when earned by the corporation and again when distributed to the shareholders), and (c) the QSBS gain exclusion only being applicable to 50% of a taxpayer’s gain until 2010 (when the QSBS provisions changed to increase the applicable exclusion to 100%), QSBS has historically made up only a small fraction of federal tax expenditures.
For example, according to the Treasury Department, which keeps records regarding federal tax expenditures, in 1999, the first year in which taxpayers potentially were able to qualify for the QSBS gain exclusion (due to its 5-year holding period requirement), it is estimated that taxpayers effectively saved $30 million by utilizing the Qualified Small Business Stock exclusion. Between 2010 and 2014, the Treasury Department estimates that taxpayers collectively saved approximately $1.3 billion dollars by utilizing the QSBS gain exclusion. By 2023, the estimated tax savings due to the use of the QSBS gain exclusion amounts to almost $1.8 billion. Although the current estimate of tax savings is significantly increased from thirty years ago, as a share of total federal tax incentives, this is still quite small.
For comparison, the deductibility of mortgage interest on owner-occupied homes, which was limited under the 2017 Tax Cuts and Jobs Act, saved taxpayers (and cost the federal government through lost tax revenue) an estimated $35 billion dollars in 2023. Assuming that the limits on deductibility of home mortgage interest do in fact sunset in 2025, as currently enacted, the Treasury Department has estimated that in 2026 the home mortgage interest deduction will save taxpayers (and cost the federal government through lost tax revenue) over $100 billion. Thus, while the Qualified Small Business Stock exclusion remains relatively small as a percentage of overall federal tax expenditures, it nonetheless is one of the most powerful federal tax incentives available to small business owners, founders, and early employees.
Qualified Small Business Stock Eligibility Requirements
The statutory QSBS eligibility requirements can generally be divided into two broad categories – (x) requirements that the shareholder / taxpayer must satisfy, and (y) requirements that the corporation must satisfy. Each of these two general categories of requirements is outlined below.
Shareholder / Taxpayer Eligibility Requirements for QSBS
The shareholder / taxpayer eligibility requirements can be summarized as follows:
- The shareholder / taxpayer claiming the QSBS exclusion cannot itself be a corporate shareholder; however, individuals, trusts, estates, and pass-through entities may claim the benefit of the exclusion. Because trusts are able to qualify, some shareholders / taxpayers who have the enviable “problem” of having more potential gain than they are able to shelter through use of the normal $10 million or 10 times basis exclusion make use of the ability for trusts which are separate taxpayers to qualify for additional exclusions.
- The shareholder’s / taxpayer’s stock must be acquired directly from the corporate issuer (and not through any secondary market) in exchange for money or other property, or as compensation for services provided to the corporation. This requirement means that the shareholder / taxpayer acquiring their shares must acquire them directly from the corporation. While acquiring the shares from an existing shareholder in a taxable purchase and sale will not satisfy the original issuance requirement, stock which is gifted from one shareholder to another will still satisfy the original issuance requirement. For example, a parent that receives shares in an original issuance from the corporate issuer could gift shares to their child and those gifted shares would continue to qualify for the QSBS exclusion, even though the child did not receive them from the corporate issuer.
- The shareholder / taxpayer must have held the stock for more than five years at the time of sale or exchange. While significantly longer than the one year holding period required for capital gains treatment, this requirement is usually not too much of an issue for small business owners, as the time it takes a startup or other small business to be ready for an exit typically exceeds the five-year holding period requirement.
Qualified Small Business Stock Corporate Eligibility Requirements
The corporate eligibility requirements can be summarized as follows:
- The corporation issuing the stock must be an “eligible corporation”, which simply means that the corporation must be organized as a domestic C corporation. S corporations, partnerships, and LLCs are not eligible entities. Though beyond the scope of this article, business owners sometimes make the conscious decision to form their new business as an LLC (taxed as a partnership) and later convert the entity to a C corporation. This option affords two principal benefits, (x) flow-through taxation in the early years of the business’s life; and (y) the potential to exclude more than $10 million through use of the 10 times basis exclusion. Typically, a founder’s adjusted basis in their stock may be quite low (as their principal investment into the business is their services, rather than significant direct capital investment, as would typically be the case for a venture investor).
As a simple example, consider the situation in which a founder converts their business from an LLC to a C corporation at a time when the business is worth $8 million, and the founder owns 50% of the business. For the sake of simplicity, let’s ignore the impact of any valuation discounts which might otherwise be applied, such that we can simply say that 50% of the business would be worth $4 million. This would then mean that the founder’s adjusted basis in their stock for purposes of the 10 times basis rule is going to be $4 million, as the amount of a taxpayer’s QSBS exclusion under the 10 times basis rule is determined according to the fair market value of the property contributed to the corporation by the taxpayer at the time of the conversion (and not the taxpayer’s carryover basis as would be applicable for all other non-QSBS purposes).
Resultantly, under the under the 10 times basis rule, the founder’s QSBS exclusion becomes $40 million (and would apply to any post-conversion gain). It should go without saying that there are some complexities around this option, and it is ideally not an option that one should stumble into blindly, but should be guided by knowledgeable tax and legal counsel to avoid potential pitfalls. You can read about the benefits of forming your business as an LLC and later converting to a C corporation here.
- At the time that the stock is issued to the taxpayer, the corporation cannot have “aggregate gross assets” in excess of $50 million. The term “aggregate gross assets” is a term of art in this context, but nonetheless, for most early stage and pre-financing small businesses, this requirement is seldom an issue; however, startups that have gone through several financing rounds may have to pay more attention to this requirement. Once a corporation has more than $50 million in aggregate gross assets, further original stock issuances from the corporation are no longer eligible for the QSBS exclusion; however, previous original stock issuances are not adversely affected and will continue to remain eligible for the QSBS exclusion.
- The corporation must satisfy an “active trade or business” requirement during substantially all of the time that the shareholder / taxpayer claiming the QSBS exclusion has held the stock. The active trade or business requirement will be satisfied if the corporation demonstrates that at least 80% of its corporate assets, by value, are utilized in the conduct of one or more “qualified trades or businesses” and the corporation is an “eligible corporation”, as discussed above. The “qualified trade or business” requirement is discussed in further detail, below.
The requirement that the corporation satisfy the “active trade or business” requirement during substantially all of the shareholder’s / taxpayer’s holding period can lead to some interesting possibilities. For example, suppose that a shareholder receives their stock in the corporation at a time when the corporation is taxed as a C corporation. Two months later, the corporation makes a valid S election, which is terminated shortly thereafter by the issuance of a second class of stock. Does the fact that the corporation was treated for tax purposes as an S corporation for a short period of time adversely impact eligibility for the QSBS exclusion? As you might expect from the emphasis in the preceding sentence on the term “substantially all”, the answer is “it depends”. Neither the statute nor the IRS has defined what the term “substantially all” means in this context, so there is some ambiguity (and potential flexibility) in how to properly interpret this requirement.
- The corporation must be engaged in a “qualified trade or business”. The term “qualified trade or business” is again a term of art in this context, but what is and what is not a qualified trade or business is one of the more nuanced questions when it comes to QSBS eligibility. IRC Section 1202(e)(3) defines a “qualified trade or business” by exclusion – it says what a “qualified trade or business” is not and anything else therefore qualifies. As discussed below, while the excluded categories of trades or businesses seem broad, they have generally been interpreted narrowly by the IRS; however, the available guidance is somewhat fragmented and inconsistent.
The qualified trade or business requirement is one of the most common issues for taxpayers as it is in essence a qualitative test, and a somewhat common misconception is that any tech business qualifies. While many tech companies (and non-tech companies, for that matter) potentially qualify, broad categorical statements can be misleading and misunderstand the issue. At the hypothetical extremes it is clear what qualifies and what does not; however, there is a significant gray area in the middle where reasonable minds may differ as to whether the requirement is satisfied, or not.
As an example, using the disqualified trade or business of “health”, while the trade or business of a physician who diagnoses and treats patients in a clinical setting for specific medical conditions will not qualify for the QSBS exclusion, a physician who creates a trade or business which develops and markets a mind/body wellness wearable device and mobile app might qualify.
In particular, if the device and app are not intended to treat any specific medical condition, but instead are focused on promoting the user’s general wellbeing (e.g., increasing energy levels, boosting overall mood, improving sleep habits, promoting mindfulness, etc.), the medical device and app are not cleared by the FDA to diagnose or treat any particular medical condition, and the company does not hold itself out as dispensing any medical advice, then this business might fall outside the categorically excluded area of “health”, as discussed further below. The reason the wearable device and mobile app potentially qualify, even though arguably related to the field of “health” is that the core asset of the company is its proprietary intellectual property assets (the wearable tech and mobile app).
In addition to these general corporate requirements, numerous other requirements and limitations apply, including those on (a) working capital as a percentage of total assets utilized in a qualified trade or business; (b) corporate real estate holdings; (c) ownership of minority interests in portfolio stock or securities; and (d) certain redemptions by the corporation of its own stock.
The “qualified trade or business” requirement is explored in greater detail below; however, it should be noted that there are numerous potential pitfalls that taxpayers must be aware of to preserve Qualified Small Business Stock eligibility which are beyond the scope of this article.
IRS Guidance on the “Qualified Trade or Business” Requirement for QSBS
As mentioned above, the “qualified trade or business” requirement from IRC Section 1202(e)(3) is a qualitative test that excludes certain categories of trades or businesses from eligibility for the QSBS exclusion. Those excluded categories of trade or business are the following:
- Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
- Any banking, insurance, financing, leasing, investing, or similar business;
- Any farming business (including the business of raising or harvesting trees);
- Any business that involves the extraction of natural resources (e.g., mining for a natural resource, drilling wells for extraction of a natural resource, fracking for natural gas, etc.); and
- Any hospitality business (e.g., operating a hotel, motel, restaurant, or similar business).
The list above is taken almost verbatim from IRC Section 1202(e)(3) because, looking at the plain wording of the statutory language, it appears that a large swath of potential trades or businesses are excluded from QSBS eligibility; however, the manner in which the IRS has construed and interpreted the active trade or business requirement is actually fairly narrow, but also somewhat disjointed and without articulating clear standards.
The IRS has provided administrative guidance on the interpretation of the active trade or business requirement through several private letter rulings (“PLR”) and a Chief Counsel Advice (“CCA”) memorandum. As of May 2024, the IRS has issued eleven PLRs on the subject of the active trade or business requirement. The table below itemizes those eleven PLRs, and provides a brief description of the subject thereof.
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PLR |
Type of Trade or Business |
QSBS Brief Summary |
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Health / Pharmaceutical Industry |
The corporation provided products and services primarily in connection with the pharmaceutical industry to help clients commercialize experimental drugs. IRS concluded the corporation was engaged in a qualified trade or business notwithstanding the proximity of the trade or business to the field of health. The corporation did not offer a service in the form of individual expertise. Instead, its activities involved use of specific manufacturing assets and IP. IRS analogized the corporation’s trade or business to being akin to a parts manufacturer in the automobile industry. |
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Health / Laboratory Testing |
The corporation used proprietary IP and other technologies to provide more complete and timely information to healthcare providers. The corporation used proprietary IP and technology to provide specific patented testing services. The corporation’s clients were doctors and healthcare providers. Tests performed did not diagnose or recommend treatment, but only measured whether items tested for were present or not present. The corporation’s employees were well educated, but also received up to a year of training to perform patented tests, and outside skills and knowledge were not relevant to performing the corporation’s patented tests. IRS determined that the corporation was not involved in a trade or business in the field of health and did not have as its principal asset the reputation or skill of one or more of its employees. The corporation did not provide medical care to patients, but simply performed testing at healthcare provider’s request. Tests performed did not provide a diagnosis or recommend a treatment, and the skill or ability of the corporation’s employees was not the determining factor in the corporation’s success. |
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Brokerage Services / Insurance |
The corporation’s trade or business involved acting as an insurance agent or broker under two different business models (direct appointments and wholesale). The IRS acknowledged lack of definition for “brokerage services” in IRC Section 1202 and noted presumption of plain meaning interpretation in statutory construction when a statute is otherwise lacking or unclear. The IRS concluded that a broker therefore is “one who acts as an intermediary” and found that the corporation’s trade or business extended beyond simply acting as an intermediary. The corporation provided valuable administrative services which were differentiable from the provision of “brokerage services”. The IRS ultimately concluded that the corporation’s trade or business was not a prohibited trade or business in the area of brokerage services. |
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Health / Manufacturing Medical Devices |
The corporation’s trade or business involved the manufacture of specialty products as prescribed by third-party health care providers. The corporation’s employees worked on prescriptions referred by health care providers to evaluate, measure, design, fabricate, manufacture, adjust, fit, and service specialty medical products to individual referred patients. The corporation’s revenue was generated by the sale of these specialty products. The IRS concluded that the corporation was not involved in a health business within the meaning of IRC Section 1202(e)(3). The corporation provided value to customers in the form of tangible products. The corporation’s business was more akin to custom manufacturing than to offering medical advice or services based on individual expertise. Although the corporation’s products are associated with the health industry, the corporation’s business did not involve performing services in the field of health, and the principal asset of the trade or business was not the skill or reputation of one or more of its employees. |
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Health / Software to Optimize Medical Treatment |
The corporation’s business was to develop and commercialize software to assist medical providers in providing medical treatment to individual patients. The goal of the software was to make medical treatment more effective by optimizing the patient’s use of medical treatment or medication. The corporation did not practice medicine, have patients, and was not licensed to issue prescriptions. IRS concluded that the corporation was not providing health services within the meaning of IRC Section 1202(e)(3). The corporation was a technology company developing software for medical providers and patients. The corporation’s business was not in providing health services, but rather in creating an asset to be utilized by their customers in the healthcare industry. The corporation’s value to customers also was not primarily in the form of individual expertise. |
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Health / Retail Sale of Pharmaceutical Drugs |
The corporation’s business involved the retail sale of a limited number of drugs, which the corporation did not manufacture. Employees of the corporation included several pharmacists who filled prescriptions received from physicians. Other employees coordinated insurance coverage with respect to the prescription orders. The IRS concluded that the corporation was not involved in the provision of medical services to patients. The corporation’s employees (other than pharmacists) were not certified healthcare providers. The corporation’s pharmacists’ role was limited to filling prescriptions and occasional interaction with patients which were incidental to provision of prescriptions. The corporation did not provide diagnostic services or medical care to patients or physicians and all revenue were generated from sale of drugs. The IRS concluded that the corporation was not involved in a trade or business involving the performance of services in the field of health or where the principal asset of the trade of business was the reputation or skill of one or more of its employees. |
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Skill or Reputation of One or More of its Employees / Enterprise Cloud Application Services |
The corporation’s business involved enterprise cloud application services software which provided solutions tailored to the operating functions and industry-specific challenges of their clients. The corporation’s employees possessed technical skills and knowledge which allowed for the effective implementation and the quality of the corporation’s services; however, the corporation’s employees were also trained on one or more of the corporation’s specific delivery processes and methodology packages that were unique to the corporation, and which could not be utilized by the employees at any other employer. The corporation recruited and trained new employees with the technical skillset to perform services using its methodology packages. The IRS concluded that the principal asset of the corporation was not the reputation or skill of one or more of its employees, but the intellectual property held by the corporation itself in its proprietary service delivery processes and methodology packages. |
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Consulting |
The corporation’s business involved data migration services to businesses. To understand its customers’ needs, the corporation created a transformation assessment plan, and its service delivery teams would determine an optimized cloud and data transformation roadmap based on assessment outcomes. The corporation’s team members would often integrate into the customer’s team on a full-time basis to orchestrate and troubleshoot the data migration and work to implement the data migration, as well as provide limited advice and counsel when working with a customer’s team. The corporation also provided post-migration managed technical services, which included monitoring and resolving incidents. The corporation’s billings to customers for services it performed represented billing for implementation of services and embedded advice, and the corporation did not separately bill for advice and counsel. The IRS determined that while the corporation provided advice and counsel as part of the process of determining a client’s data management needs, the advice and counsel was ancillary to and supported the sale of the implementation work the corporation’s employees perform. The IRS also noted the fact that the advice and counsel component was not separately billed to clients. The IRS concluded that the corporation was not engaged in a trade or business involving the performance of services in the field of consulting. |
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Consulting / interim/temp staffing services |
The corporation operated as an interim staffing services business with a focus on matching experienced executives and managers with the staffing needs of its clients. The corporation provided two main categories of staffing services that included interim staffing and executive search. Interim staffing services consisted of matching professionals with the corporation’s clients’ self-identified needs as temporary or interim employees for particular positions or projects. The corporation billed clients at an agreed upon rate for the time professionals spent on projects. The corporation billed for engagement oversight and project communication services provided by its own employees. The corporation also provided executive search services, which consisted of placing permanent professionals in executive positions with its clients. The corporation’s clients provided the specifications for the desired executives and the corporation’s employees searched for candidates based on the client-provided criteria and specifications. The corporation’s fees for executive search were equal to a percentage of the executive’s actual first year compensation. In respect of the corporation’s temporary staffing services, once professionals were provided to clients, the clients were considered the employers of the professionals and the clients were responsible for the supervision of the assigned professions, and the provision of all resources, workstations, and other tools for assigned professionals. The IRS concluded that the temporary staffing portion of the corporation’s business was not engaged in a trade or business involving the performance of services in the field of consulting, or where the principal asset of the trade or business was the reputation of skill of one or more of its employees. |
In addition to the eleven PLRs outlined above, the IRS has issued one additional piece of administrative guidance in the form of CCA 202204007. I’ve written about CCA 202204007 at length, which you can read about here.
As can be seen from the patchwork of private letter rulings outlined above, the guidance from the IRS has been generally favorable, but somewhat fragmented. That fragmentation is likely to persist for the indefinite future, as the IRS announced in Revenue Procedure 2024-3 that it will no longer issue private letter rulings or determination letters on the qualified trade or business issue of IRC Section 1202(e)(3). The IRS has apparently decided that it intends to resolve ongoing questions related to the qualified trade or business issue through the issuance of a revenue ruling, revenue procedure, regulation, or otherwise.
It is unclear how long it may take the IRS to produce any such guidance, and with ever-changing budgetary constraints and priorities, it could potentially be years before any such guidance is finalized. In the long term, this development may bring greater clarity for taxpayers wrestling with the qualified trade or business issue; however, in the short term, adding IRC Section 1202(e)(3) into the “no ruling” area leaves taxpayers without the ability of seeking a private letter ruling.
Qualified Small Business Stock: Concluding Thoughts
The QSBS exclusion is a valuable tax incentive that is increasingly a topic being covered outside of esoteric tax practitioner areas. The QSBS eligibility requirements are also sometimes relatively complex, and this is an area where what you don’t know can hurt you.
Taxpayers with questions about Qualified Small Business Stock can contact David Bellumori at david.bellumori@berliner.com to discuss their situation.